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If you’re looking to grow your net worth and eventually stop working, you’ll need to build a portfolio of assets that create positive cash flow to supplement your income. In order to do that, you need to understand the difference between assets and liabilities and be able to apply them to your own personal balance sheet and income statements.
The accounting definition of an asset is anything tangible or intangible that creates value for its owner. On a balance sheet, you would see an asset reflected as positive economic value controlled by that company or person.
Examples of assets:
- A degree from a university
The accounting definition of a liability is an obligation to pay an entity for something, such as a past or future transaction. You can also think of a liability as a claim on an asset. On a balance sheet, you would see a liability reflected as a negative economic value controlled by someone other than you or your company.
Examples of liabilities:
- Credit Card Debt
- Home or building mortgage
- Line of Credit
- Student Loans
Why Is This Important?
To make this as simple as possible, I’ll refer to the Rich Dad Poor Dad definitions. An asset is anything that puts money into your wallet, whereas, a liability is anything that takes money out of your wallet.
Let’s apply this logic to our financial statements:
The above definitions create a very distinct connection between a balance sheet and an income statement. Following this logic, anything that would create value on your balance sheet would be considered income and anything that takes value out of your income statement is considered an expense.
If you own a home, can you accurately place its assets, liabilities, income and expenses?
Working through this exercise of placing your home and its expenses you see how a home is really a liability, not an asset. Why? Because every month, your home takes money out of your pocket in the form of a mortgage, real estate taxes, insurance, utilities and other expenses related to taking care of the home.
Action: take the next 15 minutes to write down the value of all your assets and liabilities and fill out these balance sheets above.
There’s obviously more to assets and liabilities, but if you can grasp this basic concept and definition, you’ll be better off than many people. If you think of money in the term of money into my pocket or money out of my pocket, you’ll naturally change the way you think about money. You’ll begin to see money as a vehicle – you just get to choose where that vehicle goes. Do you want material objects? How about a fancy car? Or maybe a large nest egg to retire on? Better yet, how about retiring early and travelling the world? You decide, then take the appropriate financial steps to get there.
-My Strategic Dollar